Questions hover over Air Canada subsidiary Rouge on second anniversary

CP

MONTREAL - In its short life, Rouge has been credited with giving Air Canada a financial boost and shaking up the country's airline industry, but at least one analyst says the parent company may be digging itself into a hole with its expansion strategy.

By stuffing its planes with more seats and paying lower wages, the airline subsidiary has dramatically cut costs and provided a travel alternative for consumers who don't mind sacrificing space for cheaper prices.

Analyst David Tyerman of Canaccord Genuity says Rouge appears to be a financial success even though the company doesn't segment the subsidiary's results.

"I think the proof of that would be that they've rolled it out so aggressively," he said.

From an initial start with four planes, Rouge celebrates its second anniversary on Canada Day with 33 narrow-body and larger aircraft that mainly serve southern sun destinations and Europe.

Flights have also been added to Osaka, Japan, Lima, Peru, and six U.S. vacation spots. Domestically, Rouge recently began connecting Toronto to Abbotsford, B.C., and Sydney, N.S. Next year it will add London Gatwick.

Some of the destinations are new, others are destinations previously covered by the mainline carrier. Since 2009, Air Canada (TSX:AC) has increased its international capacity by 50 per cent, partly due to Rouge.

That has put extra pressure on rivals such as Transat AT (TSX:TRZ.B), Sunwing, WestJet (TSX:WJA) and Signature Vacations to keep prices low.

"Everybody complained about pricing to the sun destinations last winter. Rouge was part of the problem," Tyerman said.

The extra competition is good for consumers, especially those willing to put up with less legroom, he said. Rouge has tinkered with the airplanes by adding some business class seating to appeal to passengers willing to pay a little more for extra space.

By the end of 2017, the Rouge fleet is expected to reach the 50-plane maximum currently permitted under union contracts.

But Ben Cherniavsky of Raymond James has warned that Air Canada hasn't fully heeded the lessons of Tango, its first low-cost airline effort that collapsed in 2004.

He said Air Canada runs the risk of "diluting" key hubs and creating brand confusion among customers by operating flights to Abbotsford and Gatwick on Rouge, while the mainline carrier flies at higher prices to nearby Vancouver and Heathrow airports.

Cherniavsky said passengers will travel one hour by land to Abbotsford for discounted flights. The analyst also said Air Canada will have to match domestic rival WestJet's lower fares to Gatwick, potentially prompting some Heathrow passengers to switch London airports.

That could have potential implications across the airline's network, he wrote in a report, adding it may be cheaper to buy a Rouge ticket to Gatwick from Winnipeg and get off in Toronto, than to fly on the mainline carrier between Winnipeg and Toronto.

"What remains to be seen is whether or not they are simply digging themselves deeper into a hole."

Air Canada said its senior executives were not available for an interview. In its last quarterly conference call on May 12, Ben Smith, president of passenger airlines, said the market is starting to notice positive change.

"With our revised and enhanced model with Rouge, with our different cost structure now at regional and at mainline, we can access pockets of demand all over the place, in particular the leisure markets that were not attractive to us in the past."